How to determine whether a HELOC or cash-out refinance is best for you

How to determine whether a HELOC or cash-out refinance is best for you

Although many homeowners want to refinance to reduce their mortgage payment, others want to use their home equity for home improvement projects, tuition expenses or debt consolidation. Homeowners who want to take some of the equity from their home can choose a cash-out refinance or a home equity line of credit (HELOC). A third option is a home-equity loan, but fewer banks offer these second mortgage loans today.

“One benefit of getting a cash-out refinance is that you can save money by using the cash to pay off credit cards, which have much higher interest rates,” says Brian Koss, executive vice president of Mortgage Network in Danvers, Mass. “You could also use the cash to make home improvements that increase the value of your home.”

Choosing between a HELOC and cash-out refinance

The appropriate financial decision about whether and how to access your home equity depends on your individual circumstances.

“In some ways, the comparison between a HELOC and cash-out refinance is apples and oranges,” says Guy Silas, a branch manager with Embrace Home Loans in Rockville, Md.

A cash-out conventional loan is a safer path because the interest rate is typically fixed for the life of the loan, Silas says. HELOCs typically have a fluctuating interest rate.

“With the lowest rates in our lifetimes, cash-out refinances make more sense for most people than HELOCs,” Koss says. “HELOCs are tied to the prime rate, which varies over time. Right now, the prime rate is at its lowest point, so if you get a HELOC, you should expect your rate to go up over time.”

Another potential drawback to a HELOC, Koss says, is that they have a defined draw period, typically 10 years, during which you pay only the interest on the credit you use. Unless you repay the entire balance early, the HELOC converts to a fully amortizing shorter period after the draw period. During the repayment period, your monthly payment will be higher because you’ll be paying off the principal, potentially at a higher interest rate.

However, Silas points out, your choice of a HELOC or cash-out refinancing depends in part on your plans for the cash.

“A cash-out refinance is better suited for longer-term borrowing needs that will not be extinguished for many years,” Silas says. “HELOCs are most beneficial for short-term financing needs. HELOCs can be used as a revolving credit instrument allowing the consumer to use it, pay it down, and then re-use it again.”

A cash-out refinance has one payment that’s tied to a fixed rate over as many as 30 years, creating a lower monthly payment that doesn’t go up, Koss says.

However, cash-out loans carry higher closing costs as well as the requirement to establish tax and insurance escrow accounts, Silas says.

“HELOCs are often advertised with ‘no closing costs,’ but that is conditioned on the consumer keeping the account in existence for three years,” Silas says. “If they pay it off early and close the account, in most cases the closing costs are due from the consumer.”

Borrowing limits and qualifications for cash-out refinancing and HELOCs

Most cash-out conventional loan programs are limited to a 75 to 80 percent loan-to-value, Silas says, while most HELOC programs allow for a combined loan-to-value (CLTV) of 85 to 90 percent.

“The distinction is that the CLTV combines the existing first mortgage and the proposed HELOC as a percentage of the property value,” Silas says.

Loan-to-value compares the amount you’re borrowing with the current appraised value of your home. For example, if a loan program is limited to 80 percent LTV and your home is valued at $400,000, your total mortgage balance must be $320,000 or less.

Qualification requirements are similar for both a cash-out refinance and a HELOC, with borrowers generally needing good credit, the ability to make the housing payment or payments and an appraisal.

“The calculations for a HELOC are based on the assumption that the HELOC is fully extended to its limit,” Silas says. “However, some banks and credit unions will qualify the borrower on the interest-only payment as opposed to a principal and interest repayment required on conventional loan programs.”

Any choice to access the equity in your home comes with consequences. First, when you increase your loan balance with the amount of equity you take out of the house, your housing payments could iese, depending on the interest rate and loan terms compared to your current mortgage. If you chose to refinance at a lower rate without taking cash out, your balance would be lower, reflecting the payments you’ve made on the property. Second, borrowing from your home comes with the risk that if you cannot make the payments on either your refinanced mortgage or your HELOC, you could be forced to sell your property or lose your home in a foreclosure.

Understanding the potential risk and the details of any loan decision isessential to making an informed decision.

“Getting a cash-out refinance can put you in danger of losing your home if you can’t make the payments,” Koss says. “You could also run into trouble if you pay off your credit cards but aren’t able to control your spending and run up your card balances again.”

Deciding the best way to access your home equity depends on your needs and time horizon, Silas says.

“If the primary objective is a need for quick and easy access to capital, as well as a relatively short term such as one to three years, the HELOC is typically considered superior due to its ease of access, limited upfront costs and interest costs based only on the amount of the line used,” Silas says. “If instead the consumer has a longer horizon and cannot afford the payment shock of rising interest rates, the cash-out refinance is the path to pursue.”

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